Rupal Bhansali details her investment philosophy as portfolio manager of Ariel International Fund and Ariel Global Fund.
Past performance does not guarantee future results. Investments in foreign securities may underperform and may be more volatile than comparable U.S. stocks because of the risks involving foreign economies and markets, foreign political systems, foreign regulatory standards, foreign currencies and taxes. The use of currency derivatives and exchange-traded funds (ETFs) may increase investment losses and expenses and create more volatility. Investments in emerging markets present additional risks, such as difficulties in selling on a timely basis and at an acceptable price. The intrinsic value of the stocks in which the Funds invest may never be recognized by the broader market.
Both Funds seek long-term capital appreciation. Ariel International Fund invests primarily in foreign equity securities in developed international markets and Ariel Global Fund invests primarily in equity securities of both domestic and foreign issuers in developed or emerging markets. For a current summary prospectus or full prospectus click here.
Question: What are the key differences between your investment philosophy and other active managers in the international/global space?
Answer: The key thing that makes us different is our goal to seek superior risk-adjusted returns, not just superior returns. And so, we have woven the principal of risk management into the investment process. Additionally, we believe true alpha comes not from collecting information but from connecting information. In decades past, managers established local offices all around the world, and historically collecting information gave them an edge in achieving superior performance. Today, however, information is available everywhere—so simply having access to it is not enough. This is why, instead of having many regional offices, my team is located in one central office in New York, where we interpret and debate available information in order to connect it to form insights, in order to produce alpha. Last but not the least, we approach research as business analysts, not financial analysts. We believe things happen in the business first, then manifest themselves in the numbers. By doing research at the front end as opposed to the back end, we secure an early advantage.
Question: How do you practically apply the theories of risk management and return management when it comes to the construction of your portfolios?
Answer: Every member of the team is thinking about risk and applying that risk management framework on a daily basis. Here are some specific ways in which we have incorporated this risk management principle:
- We start out with negative screening, which is to say we look to eliminate stocks rather than create a short list of them. The basis of elimination is to first understand the risk factors a particular investment opportunity has, even before thinking about what returns that business can make. We look for key risk factors that can expose us to permanent loss of capital, such as business model risk, corporate governance risk, acquisition risk, and financial leverage risk.
- The second way we attempt to avoid risk is: in any investment debate, every analyst on the team must discuss, defend, and present not only what can go right, but also what can go wrong. We quantify how much we can lose if the worst case scenario materializes. So from the beginning, not only do we identify the upside potential, but we also estimate the downside risk.
- Finally, at the portfolio construction stage, I may choose to own stocks not for their return potential, but for their risk management or diversification potential. That is not typical in most portfolios, where stocks are usually held for how much they can go up, not how little they will go down or how they may contribute to reducing overall portfolio risk. That is what makes us different in our portfolio construction compared to many other money managers.
Question: Can you define what risk means to you?
Answer: Many confuse risk with volatility, whether measured by standard deviation or tracking error or some other metric. To us, risk is about permanently losing money. If you avoid losing money, that helps to preserve capital. And if you preserve capital in down markets, you can compound capital at a faster and better rate in up markets. So that’s how we think about risk: permanently losing money, not temporary fluctuations in stock prices.
Question: What valuation metrics are most important to you?
Answer: Because we operate in international and global markets, different geographies and businesses have different risks and different rules. Therefore, we pay attention to factors that translate around the globe. Although we use various valuation methodologies, we believe normalized returns on capital employed (ROIC), relative to the equity cost of capital (discount rate) and discounted free cash-flow valuation methodologies are most helpful in comparing businesses across borders. Such financial analyses allow us to compare a high-growth, high-risk company in Brazil versus a low-growth, high-return company in Great Britain. By leveling the playing field, we can compare and contrast competing investment ideas across geographies and sectors. For us, this is a superior alternative to a conventional reliance on price/earnings multiples, which do not capture all these facets.
Question: What risks typically come with your investment philosophy? How do you limit it?
Answer: An area where we tend to differentiate ourselves from many others in the industry is that we are independent thinkers. In the short term when the market disagrees with our point of view, we can appear wrong even if we are right in the long term. Very often, we have ideas that are not yet appreciated by the market. In fact, we often own stocks that are very out of favor. Until one is proven right—as the company reports earnings, cash flows and valuations improve, and the market re-rates the company and gives it the valuation and rating it deserves—we have to exercise patience and not capitulate in the interim. That means taking short-term pain for long-term gain. We ask our own investors to do the same: to judge managers on the rigor of their process and quality of their portfolio, rather than their short-term performance.
Regarding portfolio construction, another area that sets us apart is our belief in having a diversified portfolio of uncorrelated investment ideas, so that one big “all in” bet does not drive the performance of the entire portfolio. For example, some managers may have made a big commodities bet, wagering on the super cycle persisting for many years. One can look like a genius if the bet works out, but it can also wipe you out if you are wrong. We avoid making such large, thematic bets. We prefer many individual decisions on a bottoms up basis rather than a gigantic one so that performance outcomes are less binary and more bankable.
Question: What are the biggest mistakes investors are making today, and how are you avoiding this in your own portfolio?
Answer: I think one of the biggest mistakes investors are making today is excessive attention to earnings risk and insufficient attention to balance sheet risk. Corporations have gone on a borrowing binge and that increases risks for equity shareholders. This increased financial leverage is not priced into stocks. When the market gets around to worrying about that risk, it will be too late to protect oneself. Prevention is always better than the cure. We are proactively preventing exposure to balance sheet risk by owning more net cash balance sheet companies compared to indebted ones and among indebted ones, favoring those with superior credit profiles such as investment grade rated versus junk rated.
Question: What about opportunities investors are missing?
Answer: Investors are used to thinking in terms of labels, such as growth, value, small-cap, and large-cap. Intellectual property does not neatly fall under the heading of any such label yet. But just as high-yield and private equity once lacked a label and are now legitimate asset classes, we think that over time, people will recognize the value of intellectual property.
Here is why: We all know the world is becoming more digital. Machines are becoming more intelligent, phones are becoming smart, and even cars are connected to the web. Intellectual property, research and development, and patents will become more valuable as more software is embedded in all varieties of products. We have already seen billions of dollars being paid by Google and Apple to acquire patents, and we think investors may soon do so as well. In our portfolios, we are overweight companies that invest in research and development and own a lot of intellectual property protected by patents or knowhow, which we believe could pay rich dividends in time. Our portfolios are overweight high R&D spenders or patent owners in sectors such as technology and healthcare.
Question: Many other portfolio managers have indicated the markets have gotten too expensive—that it is difficult to find ideas. Do you find this to be true?
Answer: For anybody involved in the active management space, there is a constant struggle to find ideas that meet one’s investment criteria. I think it is fair to say the task is harder after a big market rally. On the other hand, because we are not limited by geographic, sector, or market cap constraints, we can cast our net wide to “catch some fish.” Also, as our portfolios are relatively concentrated, we don’t need hundreds of compelling ideas, just a handful.
Question: Looking back through your career, what are a few of the biggest and most impactful investment decisions you have made?
Answer: I think the most impact has always come from identifying unexpected risks and returns ahead of time.
In 2012, there was a bias towards “emerging” market stocks and a bias against Japanese stocks, which were viewed as a “submerging” market. We made a contrarian decision. Japanese equities looked extremely attractive to us on a risk-reward basis so we bought them—and for the first time in my 25 year long career, my portfolio became overweight Japanese equities. After a disastrous 2012, Japan went on to become one of the best-performing markets in the world in 2013 and 2014. I think people now recognize in hindsight what a superb investment opportunity Japan represented at the time.
Question: Volatility has a negative connotation in investing. What are your thoughts about volatility?
Answer: Volatility is not risk, although the two are often conflated. Not only are we not afraid of volatility, we embrace it as an opportunity. Some of our best investment returns have come due to volatility when short term concerns are priced as if they were long lasting. For example, Toyota went through a tough phase of earnings volatility in 2012 when they faced a trifecta of headwinds from an appreciating currency, a brake-pad failure and recall problem, and a weak end market. The earnings volatility created stock volatility and provided an opportunity to own a winner at a large discount to its intrinsic long term value. Patience paid off over the next few years. Volatility is the friend of the long-term investor and the enemy of the short-term investor.
Question: What do investors gain by adding your fund to their individual portfolios if they already own Ariel Fund, Ariel Appreciation Fund, Ariel Focus Fund or Ariel Discovery Fund?
Answer: Ariel International Fund and Ariel Global Fund complement our other funds because we invest in the global or international markets, while the other Ariel funds focus on the domestic market. Moreover, on a stock-by-stock basis, the global funds have virtually no overlap with the domestic funds. Finally, our performance patterns tend to be different, providing diversification rather than duplication.
This commentary mentions specific stocks. The opinions expressed were current as of the date of this commentary but are subject to change. The information provided in this commentary does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. One or more of the stocks mentioned were, as of the date of this communication, and may currently be held in Ariel International Fund and Ariel Global Fund. Click here for the current schedule of holdings for Ariel’s mutual funds. Any holdings mentioned do not constitute all holdings in a Fund. Portfolio holdings are subject to change. The performance of any single portfolio holding is no indication of the performance of other portfolio holdings of Ariel International Fund and Ariel Global Fund.
by Rupal Bhansali: